The 'Carry Trade' and the 'Short Straddle Trade'

Unfortunately I don't have any trades to log this weekend, as I didn't get a chance to trade on Friday due to an overload of work, so I decided to write an opinion post on these two types of trade, why I think they are similar (despite having different stigmas) and try to explain them as best as I can. 

The Carry Trade

The carry trade is a very simple idea to make easy profit from a differential in interest rates, be it between two countries or banks.

An example of the theory (and a real-life scenario) is that if for example I took out a student overdraft of £2000, which is interest-free for my time at university. I could then take this essentially free cash and put it into a current account, earn interest on it, then give the £2k back and take the interest for my self. 

If a current account was offering 3% interest per annum, I could earn £185.45 free money. 

This is essentially a kids version of the carry trade that you see so often by market participants in the FX market. 

The real carry trade in the FX markets is exactly the same principle, but instead borrowing cash from a country with a low interest rate country, and then investing it into a bank in a country with higher interest rates. 

However this grown up version of the trade carries heavy risks. This is because whilst you are taking advantage of interest rate differentials, you are exposing yourself fully to the swings in forex markets, and if the currency goes the wrong way by a percentage higher than the interest rate differential, you effectively have lost money on a 'risk free' trade. 

So whilst you are marking this trade, you are effectively betting on low volatility. A scary thought, and a very risky strategy. 

However this is a very common trader made by day-traders, institutional investors and even hedge funds. 

This brings me to the Short straddle trade, and why I think they are two similar trades with very different stigmas. 

The Short Straddle Trade

This trade is a more complex trade, and it involves the selling of put and call options simultaneously. Options are a financial product that if you buy gives you the right but not the obligation to buy a product at a specific price (strike price), with an expiration date, wherever the spot price is in the time you have the option.
The price of the option is a small percentage of the price of the real asset. 

The tactic of selling an option is the flip side of this. So you are receiving a small fee, for giving another investor the option to buy or sell the asset at a specific strike price. Therefore when selling an option, you have a large risk to the price moving as you have the obligation to sell the asset at the strike price, regardless of the price of the asset. 

The short straddle tactic is selling a put and a call option simultaneously.
Without getting to technical, you are again betting that prices will remain stable, and have unlimited risks to the price of the asset rising or falling. 

Here is a chart to show the P&L, dependent upon the asset price when doing this strategy. 



Here you can see that as long as prices remain stable, you will make profit, however having unlimited risk to volatility in the market.

This is where the link is between the carry trade and the short straddle trade. Because both tactics are basically a bet against volatility in the market. 

However the short straddle trade is known for being a highly risky and rarely touched tactic for investors around the world, where as a carry trade is very common like mentioned before. 

The short straddle trade was a trade that was used by Nick Leeson himself. Betting that the Nikkei would hover around the 19,000 mark.

However that trade brought down a bank.